Why Investors Need Not Panic After January Sell-Off

Why Investors Need Not Panic After January Sell-Off

Equity mutual fund investors — especially those investing in emerging stock markets — started the New Year with losses as an emerging market currency crisis jump-started a flight out of riskier assets into safe-haven bond funds.

But after enjoying a 32% return in 2013, the U.S. stock market was overvalued by some measures and long overdue for a normal pullback.

Emerging markets funds lost 6.32% while the average U.S. diversified stock fund gave back 2.80% and world equity funds dipped 4.44% in January. Latin America, last year’s worst-performing region, fronted the global sell-off, diving 9.81%.

Emerging markets experienced the biggest currency sell-off since 2009. Argentina’s central bank allowed its peso to devalue by not propping up its ailing currency. At the same time, the country’s foreign reserves fell to a seven-year low, fanning fears it wouldn’t be able to make debt payments. The domino effect spread to Brazil, Indonesia, India, Mexico, Turkey, Russia, South Africa, Thailand and Ukraine, whose currencies fell to multiyear, if not all-time, lows.

As a value investor, Mark Mobius, executive chairman of Franklin Templeton, says current valuations are very attractive and believes the sell-off is “overdone and based largely on irrational investor panic.” Some countries are clearly worse off than others, but the long-term case for investing in emerging markets remains intact, he says.

“Emerging markets’ economic growth rates in general continue to be at least three times faster than those of developed markets, emerging markets have much greater foreign reserves than developed markets, and the debt-to-GDP (gross domestic product) ratios of emerging market countries generally remain much lower than those of developed markets,” Mobius wrote in a note Jan. 30.

Emerging markets currently trade at steep discounts compared with the U.S.; iShares MSCI Emerging Markets (EEM) sports a price-to-earnings ratio of nearly 11 and price-to-book ratio of 1.4, while SPDR S&P 500 (SPY) has a P/E of nearly 16 and P/B of 2.4, according to Morningstar.

“Ultimately investors will begin to pay attention to valuations after the selling frenzy fades away,” said Ronald Saba, co-manager of Horizon Active Asset Allocation and director of equity research at Horizon Investments in Charlotte, N.C., with about $3 billion in assets under management. “Cheap things can get cheaper, but at some point become compelling investments from a valuation standpoint.”

A weak manufacturing report from China spooked the markets, says Howard Silverblatt, senior index analyst at S&P Dow Jones Indices. “The old saying that ‘When the U.S. gets a cold, the world gets pneumonia’ may now extend to ‘When China gets a cold, emerging markets and Asia get pneumonia,'” Silverblatt wrote in a note released Feb. 1.

Chinese manufacturing slipped to a six-month low in January as output and orders slowed. The nonmanufacturing sector, jobs and exports also showed weakness. China’s economy may not be growing at the double-digit pace that the world has come to expect, but it’s still expanding rapidly, says Mobius.

“There will be deceleration — but that’s OK,” Mobius wrote. “And China is embarking on a number of important reforms as it moves toward a more domestic-driven economic model.”

Mobius added: “As I see it, critics of the Chinese government seem desperate to find something wrong in China and have latched on to the idea that China’s growth is slowing. If China can achieve a growth rate in the range of 6%-8% this year, it would be incredible for any economy of that size.”

Investors pulled $3.3 billion out of emerging market mutual funds and ETFs in January after pouring in $12.8 billion in 2013, according to Lipper. U.S. fund outflow paled in comparison at $816 million. By contrast, bond mutual funds and ETFs experienced positive inflow for the first time in seven months, absorbing nearly $11 billion in new money.

U.S. Stock Market Action

The S&P 500 ended January down 3.56% to 1783 after hitting a new record midmonth. With half of the index companies having reported fourth-quarter results, earnings are estimated to grow nearly 8% year over year, according to FactSet.

About three in four companies have beat earnings estimates, while about two-thirds eclipsed sales forecasts.

The S&P has completed a small double-top chart pattern, which could turn into a bearish head-and-shoulders pattern, says Mark Arbeter, chief technical strategist at S&P Capital IQ. Should that pattern play out, it would lead to a 9% correction from the recent high, he wrote in his weekly technical report.

But signs of irrational exuberance signaling a top in the stock market have yet to appear, says Birinyi Associates, a money management and research firm. “The hope phase has yet to appear: no magazine covers, limited anecdotal stories (brokers buying multimillion-dollar houses, cab drivers giving stock tips), get-rich books and positive market stories,” Birinyi wrote in a client note released Friday.

Birinyi forecasts the S&P 500 will reach 1900 in the second quarter as corporate earnings grow 10% this year. Historically, in the 10 years in which earnings grew between 8% and 12%, the market returned as much as 45% (in 1954) but also fell as much as 30% (in 1974), Birinyi wrote.

The bears, on the other hand, believe the sell-off in emerging markets is a foreboding sign for U.S. markets.

“With emerging markets having already entered a bear market, it is likely that the weakness will spread into all indexes,” Brad Lamensdorf, chief investment officer of the Lamensdorf Market Timing Report in Westport, Conn., and co-manager of Ranger Equity Bear ETF (HDGE), wrote in his newsletter Jan. 27. “Since we count on emerging markets to serve as the world’s growth engine, this negative divergence is worrisome.”

Sector Funds

Last year’s worst-performing sector, precious metals funds took the lead in the new year, rallying 9.59%. Miners, gold and silver all still trade below their long-term 200-day moving averages, and so the recent uptrend has to be considered a countertrend rally in a decline that started 2-1/2 years ago. The sharpest upside and downside moves tend to occur below the 200-day moving average, where volatility tends to increase.

Health care/biotechnology, up 5.48%, real estate, up 3.38%, and utilities, up 1.07%, were the only other equity sectors to end the month with gains. Positive research results from biotechnology stocks — notorious for rocketing and cratering in the blink of an eye — drove the health care sector’s outperformance the past year.

Fidelity Select Biotechnology Portfolio ended January up 13%.

Investors flocked to real estate and utilities in search of higher dividends as interest rates on benchmark 10-year Treasury notes dropped 33 basis points in January to 2.67%.

“When rates are moving so dramatically, anything with a yield is going to act like a fixed-income security,” said Saba of Horizon Investments.

Consumer goods and services funds, both down about 6%, were hurt by weak retail sales and unusually cold weather keeping shoppers at home.